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The properties of plastics are attractive
to designers, manufacturers and consumers alike. In periods of high
energy and transportation costs, their strength and weight advantages
are particularly valuable. As a consequence, demand continues to
grow faster than Gross Domestic Product (GDP) in mature economies,
and at multiples of GDP in developing countries.
Feedstocks derived from oil and natural gas represent a very large
portion of petrochemical manufacturing costs. High and volatile
energy prices create tremendous uncertainty for an industry that
must make huge capital commitments to expand capacity. As a consequence,
even the largest companies are reluctant to expand without long-term,
stable and low-cost feedstock supplies.
Today, the only region seeing significant petrochemical capacity
expansion is the Middle East. However, political instability, weak
infrastructure and shortages of labor, engineering and project management
capability have slowed growth plans there as well.
No major new facilities have been announced for North America and
very little new capacity is planned for Europe or South America.
Expansion in China and India is limited by high feedstock costs
and as a consequence, the two countries will have to expand polymer
imports to keep up with demand growth.
If we experience just modest global economic growth, we will see
supply/demand balances continuing to tighten throughout the world
for most petrochemicals and plastics – including NOVA Chemicals’
two business chains, ethylene/polyethylene and styrenics. We believe
the critical supply bottlenecks for our two businesses are polyethylene
and styrene monomer. Consultant’s projections for the North American
polyethylene supply demand balance are shown below in figure 1,
and similar charts for global polyethylene and styrene can be found
on pages 41 and 48, respectively. The charts assume 3% Global GDP
growth and are the basis for our strong belief that, barring global
recession, we will see a long, strong period for our industry and
NOVA Chemicals.
 2005
MARKET DYNAMICS
The volatility of energy and polymer prices adds an important dynamic
to our markets. As long as there is some supply in excess of fundamental
demand, consumers of polymer will use inventory build-up or consumption
as a hedge against producer pricing.
Facing a series of price increases and concerns about supply limitations,
customers in North America and other parts of the world built polymer
and finished-goods inventories in the second half of 2004. By the
end of the first quarter of 2005, when energy prices were moderating,
customers sharply slowed their buying and consumed inventory. As
a result, polymer prices and producer margins turned down sharply
in the second quarter.
However, steady fundamental growth in demand prevailed and inventories
were drawn down to low levels by the beginning of the third quarter.
Customer orders picked up sharply and the demand increase allowed
producers to raise prices and expand margins.
The Gulf Coast hurricanes further reduced supply and as a result,
prices and margins exploded for many petrochemicals and plastics,
including ethylene and polyethylene in North America and in markets,
like South America, that rely on North American supply. Shortages
lasted until November when customers, helped by normal seasonal
demand slowness, again limited their purchases.
By year-end, polymer buyers in almost every part of the world appear
to have consumed inventory down to historically low levels.
In North America, published data indicates that polyethylene inventory
in producers’ and converters’ hands is down about 3 billion pounds
since March, 2005, or about 10% of annual demand. It is our view
that converters must resume high volume purchases to meet end-use
demand and rebuild inventory and that global markets will return
to tight conditions in the first part of the year. That should lead
to producer pricing and margin power in most markets, particularly
in North America. We expect 2006, 2007 and 2008 to be very strong
years for NOVA Chemicals and other basic chemical and polymer producers
as fundamental demand grows to levels that are beyond sustainable
production rates.
NOVA CHEMICALS’ 2005 RESULTS
NOVA Chemicals’ performance followed general market conditions for
the first half of the year. We had a very strong first quarter and
earned $94 million, $1.06 per share. Demand declined sharply in
the second quarter and we also experienced the first two of the
three major unfortunate events that impacted us in 2005.
A 17-second electrical utility outage, caused by a grass fire under
power lines on neighboring property, forced a sudden shutdown of
our Corunna, Ontario complex. The repair of damaged equipment and
lost business costs reduced after-tax income by $21 million.
Then we missed a good portion of the high ethyle`ne and polyethylene
margins available in the third quarter when freak tornados in June
wrecked six natural gas liquids extraction facilities in Alberta.
Feedstock to our Joffre complex was cut by almost one-third for
27 days. The lost business reduced after-tax ethylene and polyethylene
income by $24 million.
 We
scheduled as many maintenance and expansion turnarounds as possible
in 2005 to be prepared to operate at maximum rates in 2006, 2007
and 2008 when peak margins are expected for both of our businesses.
The first seven went well. The last, and largest, was disastrous.
We started a planned 47-day maintenance and expansion project for
our Corunna cracker on September 6, 2005. The plant was not fully
operational until late January 2006 and the delayed start-up negatively
impacted net income by $55 million in 2005. The project schedule
was hurt by labor availability problems, and then severely impacted
by a series of defects in three new compressors. We suffered, our
customers suffered and our investors suffered.
The full year ended with NOVA Chemicals showing a loss of $104 million
($1.26 per share). Unusual costs, charges and lost business impacted
net income by a total of $240 million.
Our stock performance during the year was very disappointing. As
you can see in figure 2, after touching an alltime high in March,
our shares were buffeted for much of the remainder of the year.
We weren’t alone, but the same leverage to the cycle we have in
positive periods hurts our shares more than others’ during more
pessimistic times, such as the second quarter. In addition, the
series of unusual events weighed heavily on our share price in the
third and fourth quarters.
PROGRESS IN 2005
As we begin 2006, we have our plants ready for full production and
look forward to at least two years without any restrictions in sales
volume. We are ready for the very strong markets a growing global
economy should provide.
In addition to cycle fundamentals we have a lot going for us as
we face the future. Alberta feedstock prices remain highly advantaged
and we think growing demand for natural gas liquids on the U.S.
Gulf Coast should result in higher relative costs for most of our
competitors. Our very large-scale and energyefficient crackers add
to our advantage, particularly when energy prices are high.
In 2005, we also proved that the unique polyethylene Performance
Products, made with Advanced SCLAIRTECH technology at our Joffre
site, provide processing and energy savings benefits to converters
and superior end-use properties for their customers. Most importantly,
our customers are willing to pay for these advantages.
In numerous applications, our polyethylene Performance Products
have proven to be equal to, or better than, any competitive alternatives.
In 2005, demand for these high-value Performance Products grew by
52% to 438 million pounds, or better than half of the current capacity
of our Advanced SCLAIRTECH technology plant. By 2008 we expect to
expand this capacity to 1 billion pounds per year and sell more
than 900 million pounds per year of polyethylene Performance Products.
STYRENICS ACTIONS
We have lost an average of $57 million per year of EBITDA in the
Styrenics business during the last 5 years. Some competitors and
many investors have given up on this business. We’re determined
and confident that we can make it successful.
About half of our Styrenics EBITDA losses came from our European
business. In October, we started up a styrenic polymer joint venture
with BP/Innovene (now INEOS). The joint venture has by far the largest
share of the European market for these polymers.
We expect the joint venture to generate a minimum of $60 million
per year of cost reduction by 2008. If the joint venture is successful,
NOVA Chemicals’ EBITDA will increase by $30 million per year, even
if there is no improvement in the European market.
We have seen a similar $30 million of negative EBITDA impact per
year as a result of two purchase contracts for 1 billion pounds
per year of styrene monomer that came with acquired styrenics businesses.
The contracts require minimum purchases and as a result of weak
market conditions we have been forced to cut back production from
our own lower cost plants.
One of the contracts expires by the end of 2006, the other by the
end of 2007. By 2008, we will be in a much stronger earnings position
even in weak markets. Of course, if markets strengthen in 2006,
the penalty we suffer will moderate or turn into a positive.
 In
January of 2006, we announced the shutdown of our Chesapeake, Virginia
site. This will allow NOVA Chemicals to lower fixed costs by $15
million per year, reduce working capital and allow us to run all
of our remaining polystyrene plants at higher, more efficient rates.
Together these three changes will position us to generate positive
EBITDA even in weak markets like the one we’ve experienced during
the past five years (figure 3).
The earnings growth we expect from our styrenic Performance Polymers
and new business developments will be the second major factor in
improving this business. ARCEL is a unique packaging foam and is
our most exciting Performance Product. It sells for about $2.00
per pound and provides superior value to flat screen TV, computer,
printer, and other electronics manufacturers by reducing damage,
returns and transportation costs. ARCEL production capacity was
up five-fold during the last three years. Despite building production
capacity as fast as we can, we were sold out again in 2005. We expect
to have 100 million pounds of capacity by the end of this year and
seven times the current capacity, or 225 million pounds per year,
by the end of 2008.
Other new styrenic Performance Polymers enable our customers to
make food packaging with superior freezer performance and freezer-to-microwave
capability. In addition, new styrenic business developments based
on unique, protectable technology are being pursued through joint
ventures in the construction and beverage cup markets.
Should we give up on the Styrenics business? My answer is an unequivocal
NO. We are doing things we can control to stop negative cash flow
- even if we do not see market improvement. I believe that when
we deliver on the promise of Performance Products, we will make
it a good business that can be sustained through an entire cycle.
As for the market itself, the fact that benzene prices have returned
to their historical relationship with crude oil and other feedstocks
is very important. There is little doubt that extraordinarily high
benzene prices and the resulting higher styrenic polymer prices
have limited the growth of styrenic materials during the past few
years. As a consequence, demand growth for the entire styrenics
chain fell below historical levels.
Since the middle of 2005, benzene prices have fallen sharply versus
crude oil, and are now at normal competitive levels compared to
other petrochemicals. This should allow more competitive pricing
of styrenic materials and a return to historic growth patterns for
styrene monomer.
The combination of stronger demand growth and the reluctance of
producers to invest in what has been a very poor return business,
should tighten supply/demand balances a lot faster than most expect.
STRATEGY EVOLUTION
Since its founding in 1998, NOVA Chemicals has utilized a five-point
strategy that reflected our highly leveraged position. We have (1)
focused on our two core product chains; (2) worked to be the low-cost
supplier of every grade of every product we make; (3) built on our
sustainable competitive advantages, including low feedstock costs
and proprietary technology; (4) invested only for high returns;
and (5) actively participated in industry consolidation.
The tight focus, and our rapid growth, resulted in tremendous leverage
to the cycles associated with our two businesses. Investors saw
our company as a vehicle with very high upside to the coming market
peaks but also significant risk to the downside.
We mitigated downside risk by building and maintaining a strong
balance sheet. We sold non-strategic assets for good prices and
we managed working capital better than any company in our industry.
Our success in developing proprietary process technology, unique
patented products and the development and acquisition of valuable
and unique forward integration technology changes the nature of
our company’s risk/reward equation.
 We
are putting more and more emphasis on product and business differentiation
in our operations, Research & Development programs and capital expenditure
plans within our two core product chains. We believe our Performance
Products and new business developments have the potential to generate
$300 million per year of EBITDA in 2008 (figure 4). That level of
cash flow and the exciting growth potential beyond will not only
add earnings at the top of the cycle but also provide a durable
earnings base at the inevitable bottom of future cycles.
The combination of more stable Performance Product margins, styrene
supply more balanced with internal consumption and large Styrenics
cost reductions will change our company. We will be positioned to
generate very strong earnings and cash flow at cycle peaks but face
much less risk at cycle troughs. I believe we will approach the
risk/reward equation of larger, more diversified companies in our
industry. That should generate higher equity price-to-earnings ratios
and cash flow than typical commodity chemical producers – and add
significant upside to most analyst projections of our stock price
during the next few years.
To close, I want to thank our employees, directors, and investors
for their support through the period of misfortune we experienced
in 2005. We are more determined than ever to reward them for their
faith in our company.
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